Section 3: Determinants of Price Elasticity of Demand

Some products are elastic (buyers are price sensitive), and some products are inelastic (buyers are not price sensitive). What makes people more sensitive to one product’s price change compared to another product’s price change? Some people will choose to not buy a car if its price increases by 10%, but are unaffected by an increase of 10% in the price of a bag of salt.

The three determinants of price elasticity of demand are:

1. The availability of close substitutes.
If a product has many close substitutes, for example, fast food, then people tend to react strongly to a price increase of one firm’s fast food. Thus, the price elasticity of demand of this firm’s product is high.

2. The importance of the product’s cost in one’s budget.
If a product, such as salt, is very inexpensive, consumers are relatively indifferent about a price increase. Therefore, salt has a low price elasticity of demand. Cars are expensive and a 10% increase in the price of a car may make the difference whether people will choose to buy the car or not. Therefore, cars have a higher price elasticity of demand.

3. The period of time under consideration.
Price elasticity of demand is greater if you study the effect of a price increase over a period of two years rather than one week. Over a longer period of time, people have more time to adjust to the price change. If the price of gasoline increases considerably, buyers may not decrease their consumption much after one week. However, after two years, they have the ability to move closer to work or school, arrange carpools, use public transportation, or buy a more fuel-efficient car.

Elasticity and the Effect of a Tax Change on the Price of the Product

If a government increases the sales tax on a product by 50 cents, does that mean that the equilibrium price of the product will increase by 50 cents? The answer is no. Typically, the equilibrium price will increase less than 50 cents. How much it will increase depends on the product’s elasticity. Let’s take a look at an example.

Let’s assume that a state government increases the tax on gasoline by 50 cents. This means that the cost of supplying the gasoline increases by 50 cents. In the graph below, the supply curve shifts leftward. Note that the vertical difference between supply curve S1 and supply curve S2 is 50 cents (the increase in the cost of supplying the gasoline). The equilibrium price, however, did not increase by 50 cents, because the demand curve is sloped at an angle. The burden of any tax is typically shared between consumers and suppliers. In the graph below, the tax is shared equally as the price increases by 25 cents.

In the graph below, the demand curve is steeper than the demand curve in the graph above. This means that the product is less elastic. Consequently, most of the burden of the tax is born by the consumers. In general, for less-elastic products (steeper demand curves), the burden of the tax is mostly on the consumers. For more-elastic products (flatter demand curves), the burden of the tax is mostly on the suppliers.